Participate and Preserve with Guided Equity Allocation (7:36)

Robert Schuster and Steve Blumenthal
Senior Director, Ned Davis Research and CEO, Capital Management Group
October 04, 2017Share

Video Transcript

Participate and Preserve with Guided Equity Allocation

TOM BUTCHER: While investors typically have a strategic allocation to equities, they may not always think about managing the risks associated with market downturns. They may, instead, simply expect to ride them out.

However, a tactical, guided equity allocation can be employed potentially to help avoid such losses, and the Ned Davis Research CMG US Large Cap Long/Flat Index serves as a proxy for this approach.

I was joined in the studio by its co-indexers: ROBERT SCHUSTER, Senior Director at Ned Davis Research (often referred to just as NDR), and STEVE BLUMENTHAL, CEO and CIO of CMG Capital Management Group (otherwise known as CMG).

BUTCHER: Gentlemen, thanks so much for joining me today.

Robert, my first question is to you. Could you summarize just how your index is different from other equity indices?

ROBERT SCHUSTER: Absolutely, Tom. So, we basically use an index that follows a proprietary model that we developed in conjunction with Capital Management Group. And, that model gauges the underlying health of the equity markets and provides an allocation to the S&P 500 [Index]. So we use typical trend and mean reverting analyses that produces a model, a daily reading for a model, that gives us an allocation to the S&P [500 Index], either 100%, 80%, 40% or 0%. And, at 0% we’re taking the equity risk off the table. And, that’s the portion that we consider flat. And, this is an index of indices, so we’re allocating to the S&P 500 [Index] on the equity side and we’re allocating the cash portion to the Solactive 13-week [U.S.] T-bill Index.

BUTCHER: Thank you. And, Steve, can you tell me a little bit about the development of the index’s methodology?

STEVE BLUMENTHAL: Sure. Well, I’m a trend following guy by nature, we’re a quantitative shop founded in 1992. Our clients are mainly other investment advisors. But, we also have an old legacy business; a wealth business. And, what we were looking for was something in the equity portion of the portfolio - that equity bucket - that could give us participation, but also risk protect. We had been using a simple 200-day moving average and I wanted something that was better than that. A lot of people trade the 200-day and we didn’t want to be around that. So, that was the start of what we looked at.

BUTCHER: Right, so that was the kind of the birth of it?

BLUMENTHAL: That was the birth of this. We were looking for something for our clients and our portfolios.

BUTCHER: Wonderful, thank you. And, Robert, besides the application of trend following and mean reversion indicators, are there any other aspects that make the index unique?

SCHUSTER: I believe so. And, following Steve’s comments, I think we capture two aspects that are a little unique for this particular model. The first is utilizing the direction, not just the level of the model, because the direction also provides additive information to our allocation to the S&P 500 [Index]. Additionally, we don’t assume normal distribution of returns, which we know the market doesn’t provide. So, as risk managers we look to systematically and incrementally get out of the market as this model deteriorates. But, we also know that there’s a risk of not participating in the market as it comes out off its lows. So, if we think about how the market actually behaves around tops and bottoms; at tops, it usually occurs over months and it usually rolls. There is a deterioration going on underneath the market. There’s lack of confirmation. There’s divergences happening. And, the model picks this up and we basically systematically reduce our exposure to the equity markets during this period. The bottoms are very different, bottoms usually occur in a very V-fashion, which means they get washed out and then they come back very quickly. And, it’s what NDR calls sort of a breadth thrust. And that breadth thrust; it’s lots of momentum, lots of fuel behind the market. So what the model does, it totally eliminates the level of the model. But, if we get a persistent improvement in the direction of the model then we’re back into the market at a 100%, with a 100% equity allocation.

BUTCHER: Steve, as a registered investment advisor yourself, can you expand a little bit more on what motivated you to develop the index with NDR.

BLUMENTHAL: Years ago I read one of Ned’s [Davis] books; it was called “Being Right or Making Money”. And, being a student of wealth and how money compounds over time, it’s very important to minimize downside risks. So, we were looking for that sort of protection. I’ve been a subscriber of Ned Davis’ work since the mid-90s, a very happy subscriber. And, there are a lot of tools on there that we would utilize to help risk manage what we were looking at. One of them was a momentum indicator. Well, we wanted something that was ours. We wanted something that measured the strength of the market, the major trends. And, we wanted a way to not move all the way and completely reduce risk. But, as the level of strength and trend starts to deteriorate, all the bad stuff tends to happen. When you look at 22 sectors [of the S&P 500 Index] and the majority of stocks across those sectors are down below their trend lines, then you start to get concerned. So, we’ve captured that in a process to measure and to make sure we have exposure. We want to participate and we want to protect.

BUTCHER: And finally, Robert, what role did NDR play in the development of the index?

SCHUSTER: NDR has a rich history of building rule-based models for institutional clients. And, our belief is that you want to take the emotion out of an emotional market that fluctuates between greed and fear. And, in this case we leveraged momentum, market breadth-type indicators and wrapped it into an intelligently designed index. Now, Ned Davis himself has a few simple rules for the market. But, the number one rule is you want to avoid major mistakes. And, this index is designed to get you out of the market in major mistakes. Now, you have to accept some losses, there’s an insurance policy around that. But, our belief is you want to stay in the game. And, if you can avoid the big mistakes then just, you know, mathematically that improves your long-term returns. And, so we believe this unique risk-adjusted approach to building an index is what we sort of consider smart beta 2.0, where we’re helping the investor manage risk in a passive instrument.